In this article, we explain the various inventory costing methods with real-world examples. We also provide a 10-step framework to help you choose the right method for your business. Read on to learn more.
Inventory costing methods determine how businesses value their inventory and calculate the cost of goods sold (COGS). These methods are essential because they influence a company's reported profits, taxable income, and overall financial health. Different inventory costing methods can provide varied results based on the same set of transactions, affecting financial statements.
Inventory costing methods are vital tools in financial reporting and business decision-making. Here are some key reasons why:
Financial Accuracy: Inventory is a significant asset on many companies' balance sheets. The method chosen affects the valuation of this asset and, subsequently, the financial health of a company.
Profit Margin Analysis: Different costing methods can influence the cost of goods sold (COGS) and, in turn, perceived profit margins. Accurate profit calculations guide pricing strategies and operational decisions.
Tax Implications: Inflationary periods can lead to different taxable incomes depending on the method applied. LIFO, for instance, can lower taxable income during rising prices, affecting a business's tax liability.
Cash Flow Predictability: Inventory costing helps businesses forecast the cash required to replenish inventory. Proper forecasting ensures smooth operations without over-investing in stock.
Industry Compliance: Certain industries have norms or regulations about inventory valuation. Aligning with these standards is crucial for regulatory compliance and investor trust.
Strategic Decision-Making: Understanding inventory costs informs decisions about purchasing, production, and sales strategies. It helps determine if items should be discounted, promoted, or even discontinued.
Below are some common inventory costing methods. We explain these briefly and provide a real-world example for each to illustrate how it works:
FIFO assumes the oldest inventory items are sold first. As a result, in times of fluctuating prices, the ending inventory is valued at the more recent costs. This method is especially suitable for perishable goods, where the oldest items should be sold first to avoid wastage.
Example: A fruit vendor buys 10 apples at $1 each on Monday and another 10 apples at $1.50 each on Tuesday. If 15 apples are sold by Wednesday, the cost of goods sold would be $12.50 (10 apples at $1 and 5 apples at $1.50).
LIFO presumes the most recently acquired items are the ones sold first. During periods of rising prices, this method typically yields a higher cost of goods sold and a lower ending inventory valuation. It's beneficial in industries with non-perishable goods and for tax advantages in certain jurisdictions.
Example: A computer hardware store buys 5 graphics cards at $200 each in January and 5 more at $220 in February. Selling 6 graphics cards in March, the cost of goods sold would be $1,320 (5 cards at $220 and 1 card at $200).
The weighted average method calculates the cost of goods sold and ending inventory based on an average cost of all items, irrespective of purchase date. This method smoothes out price variations over time, providing a more consistent inventory valuation. It's commonly employed when individual items can't be distinctly identified.
Example: A toy store has 20 dolls at $10 each. After acquiring 10 more dolls at $12 each, and selling 15 dolls, the cost of goods sold is $165, using a weighted average cost of $11 per doll.
Specific identification directly traces and assigns the actual cost of each specific item in inventory. It's primarily used for businesses dealing with high-value or unique items, like automobiles or custom jewelry. The method provides the most accurate profit margins for such distinct items.
Example: A luxury car dealership sells a specific custom-ordered vehicle that was purchased for $75,000, even though other cars in the lot were acquired for different amounts. This specific cost is directly matched to this specific sale.
The moving average method is similar to the weighted average but recalculates the average cost after every inventory purchase. This offers a more dynamic approach to inventory valuation, especially in computerized systems. It's favored by businesses with frequent inventory purchases at varying costs.
Example: A jewelry store purchases 5 rings at $100 each and then 5 more at $110 each. After selling 6 rings, they recalibrate the average cost (now $105). When they buy another batch at $120 each, the average cost is updated again.
Standard costing applies predetermined costs for inventory items, rather than the actual purchase costs. Periodically, the differences between the standard and actual costs, known as variances, are analyzed and adjusted. Industries with stable and predictable production costs often use this method for its simplicity and predictability.
Example: A furniture manufacturer sets the standard cost of producing a table at $300. At the end of the month, if the actual production cost is $320 per table, a $20 unfavorable variance per table is recorded.
This method is popular among retailers, as it estimates ending inventory based on a cost-to-retail price ratio. By taking the sales and inventory data, businesses can quickly gauge the value of their ending inventory without a physical count. It's a cost-effective method, especially for retailers with large product ranges.
Example: A fashion retailer has $10,000 worth of clothing, which is priced to sell at $25,000. If sales amount to $20,000, the estimated cost of goods sold is $8,000, based on the cost-to-retail ratio.
The gross profit method derives the ending inventory value by leveraging a company's historical gross profit rate. It's commonly employed for interim financial statements or in scenarios where actual inventory data gets lost, perhaps due to accidents or unforeseen events. While quick, it's less precise than other methods.
Example: An electronics store has a consistent gross profit of 40%. If sales were $100,000 this month and purchases were $60,000, the estimated ending inventory would be $20,000 (60% of unsold goods).
This method evaluates items based on the current cost to replace them, rather than their original purchase or production cost. Though it's more of a valuation approach than a traditional costing method, it can be beneficial in industries where the replacement costs of items vary significantly from their initial costs.
Example: A bookstore purchased novels a year ago at $15 each. If the current market price to restock the same novels is $18 each, they would value the inventory using this current replacement cost.
Here's our step-by-step framework to assist you in choosing the right inventory costing method for your business:
Begin by examining the nature of your inventory. Is it perishable or non-perishable? The shelf life of your products can inform your decision, as some methods like FIFO align better with products that need to be sold sooner.
Determine how often and significantly your inventory costs change. If costs are volatile, a method like the moving average, which constantly updates, may be appropriate. Stable costs might lean towards standard costing.
Consider the granularity you want in tracking inventory. For businesses with high-value or unique items, tracking the exact cost of each item (as with specific identification) might be essential. For others, a more generalized approach might suffice.
Determine your priority: ease of use or detailed accuracy. If you need a quick overview without detailed counts, methods like the retail inventory or gross profit method could be advantageous. For more precision, FIFO, LIFO, or specific identification may be better.
Examine how each method affects financial reporting and tax liabilities. Some methods might present a more favorable financial picture or offer tax benefits in specific economic climates.
Research common practices in your industry. Following industry norms can simplify interactions with stakeholders and ensure you're in line with expected practices.
Look at your current accounting or your inventory management system. Ensure the method you're leaning towards is compatible or be ready to make system upgrades.
Anticipate how your business might grow or change. A method that works now should ideally be scalable or adaptable to foreseeable shifts in your business model.
Engage with financial advisors or accountants familiar with your business type. Their insights can be invaluable in recognizing nuances and making an informed choice.
After implementing a chosen method, regularly review its efficacy. Business needs and financial landscapes can change, so it's essential to ensure your chosen method remains the best fit.
Remember, choosing an inventory costing method isn't a one-time decision. As your business evolves, it's wise to revisit this choice to ensure it remains aligned with your operational and financial objectives.
Sunset Electronics is a growing tech startup. They evaluated their inventory costing methods to ensure optimal financial reporting and decision-making following our 10-step framework:
Sunset Electronics deals with electronic components, some of which have shorter life spans due to rapid technological advancements.
Upon examination, the procurement cost of their key components has risen by 20% in the past year, indicating significant cost fluctuations.
Their product range consists of both common components and high-value specialized items. Hence, they need a detailed tracking system for the latter.
For common components, Sunset seeks a method that's straightforward yet precise enough for sound financial decisions.
With the observed inflation, using LIFO could reduce their taxable income by presenting a higher COGS, which is appealing for tax strategies.
Research shows tech companies often use FIFO for perishable components and Specific Identification for high-value items, aligning with industry practices.
Sunset's current software supports FIFO, LIFO, and Specific Identification without requiring major overhauls.
With plans to expand their product line, Sunset needs a flexible costing method that can adapt to their evolving inventory composition.
Their CFO, having experience with tech firms, suggests a combination of FIFO for perishable components and Specific Identification for specialized items.
After a quarter, Sunset Electronics will review the results of implementing the chosen methods, ensuring they remain conducive to their financial and operational objectives.
We hope this article has given you a better understanding of the different inventory costing methods and how you can choose the right one for your business.
If you enjoyed this article, you might also like our article on vendor management inventory agreement.
